Example 24: A blacksmith who produces a wide variety of products will lose some time in each change of production. Each transition from producing nails to producing horseshoes to producing farm implements, etc. will result in lost time. 3. “The invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many.” A worker concentrating on one type of production is more likely to discover superior methods of production than a worker whose efforts are spread over many types of production. Example 25: A blacksmith who produces only nails is more likely to discover a better method of producing nails or to invent machinery that enhances nail production than a blacksmith who produces a wide variety of products. Smith further observes that the division of labor means that even the poorer members of society benefit from the industry of a great number of people. Example 26: A day-laborer in Adam Smith’s Scotland purchases a pair of boots. How many people have contributed to the production of the boots? The cobbler – who manufactures the boots, the blacksmith – who produces the hobnails, the tanner – who tans the leather, the rancher – who raises the cattle (source of the leather), the collier – who mines the coal to fuel the blacksmith’s forge, the miner – who mines the iron ore that the blacksmith turns into hobnails, etc. In Chapter 2 of Book 1, Smith explains that the division of labor is a consequence of the human propensity to trade. This propensity to trade arises from the unique neediness of human beings: “In almost every other race of animals each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren,…Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want,…it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of.” In Chapter 3 of Book 1, Smith explains that the extent of the division of labor is limited by the extent of the market. In a small market, a worker will not be able to specialize in only one type of production because the market demand for that type of production will not be large enough to consume all that the worker could produce. Example 27: A blacksmith employed in a small village would not be able to specialize in producing only nails, because the village demand for nails would be less than the amount the blacksmith could produce. Instead, the blacksmith will produce a variety of products in accordance with the market demand. Access to low-cost transportation can extend a market and allow for division of labor. Smith explains that this is the reason why economic development has occurred first along seacoasts and navigable rivers. The low cost of water-carriage compared to land-carriage creates a more extensive market and allows for more division of labor. In Smith’s words: “As by means of water-carriage a more extensive market is opened to every sort of industry than what land-carriage alone can afford it, so it is upon the sea-coast, and along the banks of navigable rivers, that industry of every kind naturally begins to subdivide and improve itself…” Even in a modern economy, large markets can benefit more from the division of labor than small markets and are thus likely to enjoy a higher standard of living. Population density is a factor determining the size of a market. Greater population density increases the size of a market, and is associated with a higher standard of living. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 19 - 9 The Firm

Example 28: The five states with the highest per capita income in 2013 (see Chapter 5) had an average population density of about 686 people per square mile. The five states with the lowest per capita income had an average population density of about 75 people per square mile. Appendix: Think Like an Economist – Hiring an Attorney You live in a small town and you need an attorney. Aunt Marcella has died and you are the executor of her rather complicated estate. You need an attorney who is an expert at probate work to help you with probating the will. You could hire one of the two attorneys in your small town, or you could hire one of the hundreds of attorneys from the big city down the highway. Thinking like an economist, will you want to hire a small town attorney or a big city attorney to help you with this complicated estate, and why? Study Guide for Chapter 19 Chapter Summary for Chapter 19 A firm is an entity that employs resources to produce goods and services. For many types of production, firms can produce more efficiently (at lower cost) than households. The efficiency advantage that firms have over household production may occur because firms can reduce transaction costs (the costs of bringing buyers and sellers together for exchanges). The efficiency advantage that firms have over household production may occur because team production is more productive than individual production. Team production allows for two advantages over individual production; (1) specialization of labor, and (2) extensive use of capital. A problem with team production is that individuals within the team may engage in shirking (avoiding the performance of an obligation). A manager tries to limit shirking behavior. Managers will be more diligent to limit shirking if they are residual claimants. Shirking is an example of the principal-agent problem. The most common legal type of business firm is the proprietorship, but in terms of total sales, corporations are the most important type of business firm. All types of business firms are assumed to pursue profit-maximization as their chief goal. In a competitive market, the goal of profit-maximization will compel a business firm to do two things that serve the best interest of society; (1) the firm will use its resources to produce in response to consumer demand, and (2) the firm will use its resources as efficiently as possible. A proprietorship is a firm owned and operated by one individual. An advantage of proprietorships is that they are easy to form and to dissolve. A major disadvantage of proprietorships is that the proprietor has unlimited liability (the proprietor is personally liable for the debts of the proprietorship). A partnership is a firm owned and operated by two or more co-owners. An advantage of partnerships is the possibility of specialization. The major disadvantage of partnerships is that the partners have unlimited liability. This is an even bigger problem for partners than for proprietors. A corporation is an organization owned by stockholders that is considered a legal person, separate from its owners. Because a corporation is a separate legal person, the stockholders enjoy limited liability (the stockholders are not personally liable for the debts of the corporation). Other advantages of corporations include; (1) relative ease in raising large amounts of capital, and (2) corporations do not end with the death of a stockholder. The disadvantages of corporations include; (1) corporations are relatively complex and expensive to organize, to operate, and to dissolve, (2) corporations are subject to double taxation, and (3) corporations are subject to problems caused by separation of ownership and control. FOR REVIEW ONLY - NOT FOR DISTRIBUTION The Firm 19 - 10